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  1. Home
  2. / Investing

You Can Bet on Earnings Overreactions

I'll be watching closely for a chance to pick up bargains.
By TIM MELVIN Jan 12, 2015 | 01:00 PM EST
Stocks quotes in this article: AA, LAYN, WMAR, PLPC, NWPX

Tonight kicks off the biggest betting event of the year. Although millions of dollars will be wagered on the Oregon-Ohio State title game, I am actually talking about another betting tradition that attracts a lot more cash. Alcoa (AA) kicks off another six weeks of the ridiculous event known as earnings season. The chat rooms and trading desks are already buzzing with earnings strategies, and traders are concocting multi-leg options trades to bet their guesses on the accuracy of the always highly accurate analysts' guesses about earnings in the most recent quarter.

Most of the retail traders who made earnings season bets lost money last quarter, and they will lose money again this quarter. My grizzled friends who used to stalk the floors of the CBOE are again looking forward to hoovering up money out of the options market as uninformed traders set up butterflies, strangles and straddles to try to game the next month of earnings reports and estimates. Predicting earnings is a loser's game but millions of would-be traders will play it with their hard-earned cash once again starting tonight. Vassar University would have a better chance of beating the winner of tonight's football game than most earnings traders, but they are smart enough not to play a game they cannot win. Retail traders do not show the same wisdom, unfortunately.

Earnings season has been pretty good to me over the years, but that's because I make no predictions about what earnings might be for any given quarter. I wait and react to what earnings actually are and profit from companies who miss analyst expectations. Most of the time earning season will see one or two companies that are almost cheap enough to by tumble into our price range, giving me an excellent entry point. Last quarter we took advantage of a miss by Layne Christenson (LAYN) that sent the stock tumbling to a large discount to book value. The quarter before that we were able to buy shares of West Marine (WMAR) at bargain levels after it fell short of analyst expectations.

I have complained about the lack of safe and cheap stocks as the new year starts. There simply are not that many bargain issues with a margin of safety right now. All told, there are bailout 20 stocks that pass the filters of both safe and cheap; however, an additional 86 stocks pass all the safety checks and are just not quite cheap enough to purchase. An earnings miss could bring them into my buying range very quickly.

There are some interesting companies on the almost-cheap-enough list. I am a big fan of Preformed Line Products (PLPC), and I cannot help but hope they had a horrible fourth quarter that sends investors and traders running for the proverbial hills. This company designs and manufactures products and systems employed in the construction and maintenance of overhead and underground networks for energy, communications and broadband network companies. Even if the short term is rocky, Preformed has a bright future as the electric grid and communications networks in the U.S. are upgraded and repaired. The Ohio-based company also has operations in Europe, Asia, Canada and Latin America, so it will benefit from infrastructure spending around the globe as well. I would love to see this stock tumble to a sizable discount to book value from the current 1.1x book value.

I am a big fan of Northwest Pipe (NWPX) for similar reasons. Its water-pipe segment makes pipes that are used for water transmission, plant piping, energy, structural and industrial applications. It really is a tossup as to which is a bigger mess, the electrical grid or the water supply infrastructure. Once we finally get the economy solidly back on track, money will have to be spent to rebuild both and Northwest Pipe will benefit. I would love to see this stock fall to 80% or so of book value so I could scoop up the shares on my terms. Right now, the stock is trading at about 97% of book, so it is not that steep a drop.

I have no clue which companies will exceed estimates and which ones will fall short of expectations. I am not going to even attempt to guess how stocks will react to the upcoming wave of earnings releases. But I will be watching closely for a chance to pick up bargains on an overreaction. The reaction has always been more profitable for me than the predicting, and even more so during earnings season.

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At the time of publication, Melvin had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity

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